This editorial appeared in the New York Times:
The success of the Volcker Rule, unveiled this week, depends on federal regulators doing what they failed to do in the run-up to the financial crisis and have done only haltingly since then: enforce the spirit as well as the letter of the law against the wishes of powerful banks.
The rule, a pillar of the Dodd-Frank financial reform of 2010, is intended to curb recklessness by barring banks from trading for their own gain, disconnected from clients needs and demands. The sound premise is that taxpayers, who back the banks, should not be on the hook for speculation undertaken for the purpose of generating big bonuses for traders and executives.
In a hopeful sign that regulators mean business, the final version of the rule is stronger than earlier drafts in crucial ways. In particular, it is better at distinguishing impermissible self-serving speculation from allowable trading designed to lessen bank risk and serve clients.
For instance, the final rule requires that bank trading be linked to specific and identifiable risks, rather than to broad strategies that could justify any and all trading. Say a bank, acting as a middleman in a client transaction, has to temporarily hold on to a pile of bonds. To guard against the risk that the bonds might fall in value, the bank may enter into an offsetting trade. What the bank cant do under the rule is place bets on the overall direction of rates, growth, prices or other indicators. In addition, banks must demonstrate that their trades and positions remain linked to clients needs and demands, which is intended to prevent permissible trades from careening out of control.
The aim of those and other provisions is clear: Banks must not engage in banned speculation under the guise of permitted activities. Yet the rules wording is often imprecise, giving banks leeway to do just that. One provision, for instance, says that trader compensation cannot reward prohibited trading. But to truly reduce incentives to gamble, it should have restricted pay to spreads, fees and commissions, with no possibility of bonuses based on any trading gains. Similarly, a provision requiring the chief executive to attest that the bank has a plan to comply with the rule stops far short of requiring the boss to be accountable for the banks compliance, or lack thereof. Finally, the timetable for the rule is much too elastic. At the behest of the Federal Reserve, one of five agencies that devised the rule, regulators set July 21, 2015, as the rules full effective date. Under the law, the Fed could further extend the deadline, to July 21, 2017. That long lead time invites the banks to cry foul, exploit loopholes and demand special treatment, rather than get down to the hard work of compliance. It will be up to the new Fed chairwoman, Janet Yellen, to resist their cries.
In the meantime, there will be ways to tell if the banks are even trying to comply: shrinking bonus pools, traders leaving for employers not constrained by the rule and a drop in bank revenue in areas that have benefited most from excessive speculation, including derivatives, currencies and commodities. Lower revenue and bonuses from less speculation are the last thing any banker wants. But they would be the natural outcome of an effective Volcker Rule and a sign of a healthier financial system.
Which brings us back to the biggest challenge facing the Volcker Rule. Are regulators up to the task they have set for themselves?
The New York Times